A politico-economic model of public expenditure and income taxation

This paper contributes to the literature on majority voting over fiscal policies. We depart from the standard model in two dimensions. First, besides redistributing income, the government uses the net tax revenue to finance the provision of goods and services that become in-kind transfers to the citizens. By deciding on the composition of this expenditure (education, health, law-and-order, etc.), the government chooses the allocation of the benefits to the different income segments. This choice is a fundamental ingredient of fiscal policy. Second, we tackle the problem of choosing the income tax function and the composition of public expenditure by assuming that the political process selects one of these issues as the salient one. Political controversy and vote focus on this issue exclusively. The other dimension is determined in a way so as to minimize objections (obtain consensus) among the voters. We analyze the case where the salient policy is the composition of public expenditure. We show that for each voted expenditure policy, there is a unique income tax function that attains consensus. The political process we model yields that the progressiveness of the income tax schedule depends on income inequality interacted with the elasticity of substitution of the goods provided in the market and those publicly provided. This relationship is confirmed in our empirical test.Mayoral and Esteban research has been funded by the Spanish Ministry of Economy and Competitiveness Grant, through the Severo Ochoa Programme for Centres of Excellence in R&D (SEV-2015—0563) and Grant ECO 2015—66883–P, Generalitat de Catalunya Project 2017SGR1359Δ, and the National Science Foundation Grant SES-1629370. Useful comments by Jordi Caballé, Eliana la Ferrara and Kalle Moene are gratefully acknowledged. Andrew Gianou has provided us with excellent research assistance